Paying back debt is always a challenge. This is especially true if you have multiple loans with different lenders.
Having multiple loans means keeping track of different payment schedules and lender policies. And, the minimum payments you make on each loan can add up to a small fortune, making it difficult to manage your budget.
If you're looking to simplify your life and potentially make your debt cheaper and easier to pay off, debt consolidation may be the solution.
💡 Debt consolidation is when you combine your debts and take out a new loan to help pay them off. This is done in single monthly payments, instead of juggling multiple payments.
While debt consolidation can sometimes make paying back debt easier, this isn't the case in every situation. You'll want to determine if consolidating your loans actually makes sense for you.
Here are four situations when debt consolidation may be a smart move to help improve your financial situation.
1. When You Can Reduce Your Interest Rate
Debt consolidation can make sense if you're able to get a new loan with a lower interest rate than the debt you're currently paying back. On the flip side, it doesn’t make sense to consolidate if doing so means you’ll be paying back your debt at a higher rate than what you’re starting out with, increasing total repayment costs.
Your ability to qualify for a loan at a low rate depends on your credit score and income. If you have pretty good credit and are earning good money, you should be able to qualify for a consolidation loan at a reasonable rate. You might also be able to qualify for a balance transfer credit card with a 0% promotional rate, which could reduce the interest you pay down to nothing for as long as the promotional rate is in effect.
Obtaining a lower rate and reducing the total that must be repaid, however, is an ideal scenario and sometimes it just doesn’t work out that way, so be aware of the deal that’s being offered to you. The Consumer Financial Protection Bureau urges borrowers to review the fine print on their loans, as they may offer low teaser rates that could rise and end up costing more in the long run.
So, if you're considering a 0% promotional balance transfer, for example, calculate how much debt you'd have remaining when your promotional rate expires. Then, see how much interest would be charged on the remaining balance. If it’s more than the interest you'd pay under your current repayment plan, consolidation probably doesn’t make sense. If it’s less, you’re likely onto to something good!
2. When You Can Lower Your Monthly Payment
If you're currently paying back loans with high monthly payments, your budget may be stretched thin. A consolidation loan could help you to reduce the amount you pay each month, giving you more wiggle room.
Your monthly payment could be reduced if: your interest rate is lower, your repayment timeline is longer, or just simply by having a loan with a single monthly payment instead of multiple.
Remember, though: just because a consolidation loan lowers your monthly payment doesn't make it a good deal.
If you'll be paying for much longer, your loan could end up being more costly in the long run and other financial goals could be compromised since becoming debt free doesn’t typically happen overnight.
Still, if you’re in danger of being unable to make your current monthly payments because your debt burden is too high, it may be worth consolidating to avoid defaulting — even if it means paying more over time.
3. When You Find a Loan With Reasonable Fees
Since a primary goal of consolidating is to reduce costs associated with debt payment, it's important to look at the total expenses associated with your new loan. That's because, as the Indiana Department of Financial Institutions cautions, “some unscrupulous lenders charge an enormous upfront fee that they don't go out of their way to tell you about.”
Would-be borrowers from every state should heed this warning to ensure they don't pay so much in fees that they negate any savings from consolidating.
To make sure you understand all of the fees you could owe, read the fine print on the loan paperwork. Look for origination fees, administrative fees, as well as potential prepayment penalties if you decide to pay off your loan at an accelerated rate.
4. When You're Committed to Debt Payoff
Before you consolidate debt, be sure you’re committed to pulling back on your spending and keeping it under control. This will help you have a plan in place for paying off your new consolidation loan.
Otherwise, you could run into some issues and fall into a pattern of “just [kicking] the can down the road,” says the CFPB, since because simply borrowing more isn’t a great way to become debt free. You’ve still got to pay it back, or else risk ending up further in debt.
This, of course, isn’t a guaranteed drawback but it does demonstrate why it’s so important to understand what debt consolidation means. For instance, if you use a balance transfer credit card offer and can't pay back the transferred amount prior to the promotional rate ending, the interest rate may increase substantially, depleting any interest you might have saved months prior.
The same goes for a home equity loan. If you aren’t committed to sticking with the repayment plan, your house could be foreclosed on if you can’t repay the loan.
Be Smart About Debt Consolidation
The bottom line is, debt consolidation makes sense when you can qualify for financing to pay off current loans, and your new loan has a reduced interest rate and better terms.
Not only can doing so help better manage your debt, but you may also find yourself able to repay your debt much faster than originally thought.
Now that you know when consolidation makes sense, be sure to carefully consider all the best options for consolidation as it pertains to your situation and understand the ins and outs of how it works to get the most out of it.